The Case Against the Capital Gains Tax Cuts

The new budget agreement commits the President and Congress to cut capital gains taxes. That’s unfortunate. The leading plans—lowering the top capital gains rate from 28 percent to 20 percent or less, and indexing capital gains for inflation—would spur tax shelters, generate little new saving, give a windfall to the wealthy, and make long-term budget problems even worse.

But not all capital gains cuts are created equal. It is possible to craft a cut that would benefit the economy and would not cost very much—one that even two skeptics could support.

Why We’re Skeptical

This may surprise you. Capital gains are currently taxed at lower rates than most other asset income. Gains taxes are capped at 28 percent, deferred until the asset is sold, and forgiven entirely upon death or if the asset is donated to charity. In contrast, taxes on interest and dividends can be as high as 39.6 percent, and you can’t postpone indefinitely the tax on interest or dividends.

Cutting capital gains taxes would increase the difference between capital gains and other income and boost the tax sheltering industry. Shelters waste economic resources (remember the empty office buildings of the 1980s?), and make taxes less fair and more complex. They also drain revenues from the Treasury. Advocates like to assert that capital gains tax revenue rises when capital gains tax rates are cut. The result, even if it were true, is misleading. The point of shelters is precisely to shift income from highly taxed to lowly taxed forms. For example, when lower taxes on capital gains cause an executive to shelter income by switching the form of compensation from wages to stock options (which generate capital gains), revenues from capital gains taxes increase, but tax revenues from wages fall by even more, so overall revenues fall.

Capital gains tax cuts would provide a windfall for the wealthy. Advocates often claim that tax cuts are fair because most of the people who would get tax breaks have modest incomes. That’s like saying that income is equitably distributed because almost everybody has some. About three-quarters of capital gains are realized by the 3 percent of households with incomes over $100,000.

Yes, capital gains cuts would raise saving and investment, but not by much. Capital gains taxes are a small part of all taxes on saving and investment, and the effective rate on gains is already low. Much investment would be unaffected because it is financed with debt or supplied by pension funds, non-profit institutions, and foreigners who do not pay capital gains taxes in the first place. And saving is not very responsive to changes in its return. As a result, conventional estimates suggest that cutting the top gains rate to 20 percent would raise private investment by less than 0.1 percent of GDP. Even that modest gain could be erased if the tax cut increases the deficit, causing interest rates to rise.

Nor would a cut affect venture capital much. Capital gains on small new ventures are already taxed at half the rate of other capital gains. Much of the funds for venture capital come from sources that do not pay capital gains taxes and so would not be affected by cuts.

Capital gains tax cuts would also reduce lock-in—the incentive to hold assets to avoid tax. But a better way to reduce lock-in would be to tax gains at death. And lock-in may not be all bad if investors are too oriented toward short-term results, as some analysts claim.

But there are real problems with capital gains taxes: inflationary gains are taxed, gains on corporate stock are taxed twice, and the tax is often unnecessarily complex. So, what to do?

Don’t Bother With Indexing

Ideally, only the portion of capital gains not due to inflation would be taxed. This turns out to be quite complex, however, and, to avoid creating monstrous tax shelters, would require also indexing interest income and interest deductions for inflation—multiplying the complications.

Indexing, however, remains popular as a budget gimmick. Indexing future gains starting in 2002, as has been proposed, would generate a large sale of assets in that year, which would help temporarily balance the budget. After 2002, the budget cost of indexing grows and grows, causing bigger fiscal headaches down the road.

Stop Taxing Gains on Homes

Removing the capital gains tax on home sales would simplify tax compliance for homeowners at virtually no cost to the Treasury ($0.3 billion in 1993). Taxpayers would no longer stay in homes that are too big or expensive just to avoid capital gains tax. Although homes are already a good tax shelter, the proposal creates little potential for abuse, because people have only one principal residence. If financed by a lower limit on mortgage interest deductions, the cut would not have to increase the total overall tax subsidy for owner-occupied housing.

Reduce Capital Gains Taxes on Corporate Stock

Corporate profits are taxed once under the corporate income tax, and again when claimed by the stock holder as dividends or capital gains. This makes capital more expensive for corporations than for other companies, and reduces output. Cutting capital gains taxes on publicly traded corporate stock, held directly or indirectly through mutual funds, could mitigate the double-tax on corporate stock, and would cost a fraction of an across-the-board cut for three reasons. First, only about a third of capital gains are on corporate stock. Second, capital gains on corporate stock are probably more responsive to taxes than other capital gains, so more of the direct revenue loss would be offset by increases in asset sales. Third, many shelters would not work with corporate stock because stockholders cannot deduct corporate losses. Of course, if double taxation is the real problem, dividend adjustments and broader corporate tax reform should be considered.

Conclusion

A cynic might conclude that capital gains tax cuts are simply a sop to rich campaign contributors. It could be better than that, though. The proposals made here could improve economic incentives and simplify taxes at relatively little budgetary cost.